April 2021
Plenty of optimism about this economy
YES!!!!!!!!! GameStop plays to win
“Really below industry standard”
If you’re feeling risk-averse, take up chess
Which doctor will you choose?
You have back pain, so you get an MRI and ask two doctors for their opinions. Doctor #1 says your pain could have several different causes and recommends trying several treatments to see what works. Doctor #2 concludes the cause with certainty and recommends one specific treatment.
Which doctor will you choose?
Most people choose the more confident and certain Doctor #2. The logic seems obvious - doctors who are more knowledgeable and experienced should be able to confidently diagnose the correct cause and prescribe the proper treatment. Just imagine laying on the operating table looking up into the eyes of the less-than-certain Doctor #1 as the anesthesia is taking effect, with your last conscious thought creeps in: “maybe I should have chosen the more confident Doctor #2…”
The problem, however, is that certainty rarely exists in non-routine medicine. The human body is too complex, and even the best doctors’ capacities are too limited, to both know and accurately synthesize all pertinent information to reach certainty. Medicine operates (pun absolutely intended) in the world of Likelyhoods, not in certainties.
Markets are not that different from medicine! Which manager should an investor choose, one who confidently forecasts with certainty, or one who grapples within the realm of uncertainties? The preference for managers who confidently forecast with certainty “feels right”, but the performance data usually favors those who keep their overconfidences in check.
“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.”
― Mark Twain
When grappling with unpredictable future events, it can be helpful to distinguish between different forms of uncertainty. In Distinguishing Two Dimensions of Uncertainty, Fox and Ulkumen revisit the 2011 military operation that killed Osama bin Laden:
On April 29, 2011 Barack Obama made one of the most difficult decisions of his presidency: launch an attack on a compound in Pakistan that intelligence agents suspected was the home of Osama bin Laden. In an interview Obama described the raid as the longest 40 minutes of his life. He attributed that tension to two sources. First, he was not certain that bin Laden was actually residing in the compound. “As outstanding a job as our intelligence teams did,” said the President, “At the end of the day, this was still a 55/45 situation. I mean, we could not say definitively that bin Laden was there.” Second, regardless of whether bin Laden was residing in the compound, it was not certain that the operation would succeed. Asked about this concern the President cited operations by previous presidents that had failed due to chance factors, saying, “You’re making your best call, your best shot, and something goes wrong – because these are tough, complicated operations.”
The authors go on to distinguish Epistemic from Aleatory uncertainty, which I will summarize this way:
Epistemic uncertainty can be thought of as imperfect information regarding a belief that is either true or false. Whether bin Laden was in the Abbottabad compound, or not, was a binary unknown condition. Waiting for potentially additional information that might increase President Obama’s confidence that bin Laden was in the compound ran the risk of bin Laden fleeing to another hiding place, thus losing perhaps the best chance he might ever have at capturing or killing the world’s most wanted terrorist. On the other hand, unauthorized entrance into a sovereign country without their knowledge and raiding a compound of innocent civilians would greatly damage relations with Pakistan and likewise hinder future prospects of capturing or killing the world’s most wanted terrorist. Information exists that would improve our confidence in knowing whether bin Laden was in the compound, but our intelligence community just could not obtain that information - Epistemic uncertainty.
Aleatory uncertainty refers to the randomness and variability that exists in an unpredictable situation. There were many elements in the bin Laden raid that were fundamentally random and yet could swing the operation from success into failure. As just one example, changing weather conditions could require the helicopter pilots to fly at a higher and more easily detectable altitude. If similar raids were executed multiple times under similar conditions, the randomness inherent in weather conditions could lead some operations to succeed yet lead other operations to fail. Likewise with the specific positions of guards in the compound at the time of the surprise operation and countless other essentially random factors. Fundamentally random events are not predictable, so no amount of additional information would reduce this form of Aleatory uncertainty.
In August I wrote:
“Managers should be adept at parsing out Epistemic versus Aleatory uncertainties in markets. Managers can improve effectiveness by accurately identifying market dynamics in which managerial decision making cannot systematically overcome what are fundamentally unpredictable Aleatory uncertainties.”
There are a variety of benefits to thinking this way, particularly in the investment management context. One is avoiding “paralysis of analysis” - if you’ve ever felt like you have analyzed an investment so thoroughly but just could not pull the trigger, you may have been trying to find certainty in randomness. Another benefit, particularly in what are highly uncertain financial markets, is that an understanding of uncertainty leads us toward an acceptance of and comfort in probabilistic thinking.
Robert Rubin explained it this way:
“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”
This is one of many forms of “thinking in Likelyhoods”.
Behind those record inflows
How about this eye-popping statistic from Bank of America:
"The latest wave of market enthusiasm has brought with it a stunning rush of money, in which more of investors' cash has gone to stock-based funds in the last five months than the previous 12 years combined."
Yes, increasing demand for equities in the form of inflows is Likely a tailwind for equities moving forward. But beneath this statistic is an extraordinary outflow from equities starting roughly 5 months ago - not to mention the bazooka of fiscal stimulus - that makes this eye-popping inflow possible. Guess we can pop our eyes back in.
Arche-gone
Archegos Capital made the headlines seemingly overnight when its banks issued margin calls that star manager Bill Hwang could not meet. His strategy of increasing already extreme leveraging "works" on the way up, but implodes with just a minor decline. For Archegos, that meant ruin.
Makes me wonder if Bill Hwang listened in on last year’s Berkshire Hathaway annual meeting? Warren Buffett related risk-prudent investing to elementary math class:
“It is hard to think about things that haven’t happened yet. So we can experience when something like the current pandemic happens, it’s just, it’s hard to factor that in, and that’s why you never want to use borrowed money, at least in my view, buying on margin, to buy into investments. And we run Berkshire that way, we run it so that we literally try to think of the worst case, of not only just one thing going wrong, but other things going wrong at the same time, maybe partly caused by the first but maybe independent even of the first. And, you learned in, I don’t know what grade now, probably earlier than when I went to school, fifth or sixth grade, that anything, you can have any series of numbers times zero, you just need one zero in there and the answer is zero, and there’s no reason to use borrowed money to participate in the American tailwind, but there’s every other reason to participate.”
—Warren Buffett
Yes, yes, Bill Hwang’s strategy multiplied by zero.
More interesting to me though is why most (all?) of Archegos’s lenders found themselves with large and unexpected exposure to losses. They all have internal risk controls, monitoring, and oversight of their clients. So what happened?
We still do not know the whole inside story. But with respect to what we do know, like most matters, the explanations are complex. For one, Archegos arranged for their prime brokers to purchase the actual shares then bought swaps on those shares instead. Archegos captured the same economic exposure of those shares through the swaps, but the banks owned the shares to hedge the swaps that they sold to Archegos. Since Archegos used swaps, public filings and other reporting never showed Archegos as owning those shares and thus enabled Archegos to obscure the extent of their concentration risk to their lenders. Multiple banks were not only shocked at how concentrated Hwang’s portfolio had become, but were then doubly shocked to learn that there were other banks that also had highly leveraged exposure to Archegos’s losses.
Each bank perhaps would not have lent Hwang so much money had they known about the extent of his existing loans from other banks! For further reading, Matt Levine at Bloomberg has written nice analyses of the Archegos collapse.
Last month, in the context of Rocket Companies (RKT), I wrote about Resulting which refers to when decision quality is measured by outcome rather than process. When markets rise, paper profits flow, and everything *seems* okay… Resulting! I cannot say for certain, but the breakdown in the banks’ risk management may have involved conflating quality of outcome (Archegos’s paper profits - Good!) with quality of process (Archegos’s strategy - Really Bad!).
Archegos probably has every bank’s chief risk officers reevaluating everything. Risk management is complex, not least of which is because quantifying outcomes is much easier than quantifying processes. The investment management industry is full of smart people applying mathematical calculations to complex phenomena. Can we agree though that profitability is a grossly insufficient proxy for a quality process?
Shorting Shorting
Interactive Investor’s interview with Bill Ackman revealed this reflective learning from the star fund manager:
“Pershing is not a short-selling firm. We’ve shorted a couple stocks in our history. And the last one we did, I foreswore short-selling thereafter… not that I’m faint-of-heart, but I’m faint-of-heart with respect to short selling.”
—Bill Ackman, Pershing Square Capital Management
Y’all know my views on this. Short selling plays a useful role in price discovery, but is such a tough way to make money that I choose to leave that price discovery role to others. Perhaps new in the post-GME world is that prices will be inflated into a new balance with fewer short sellers willing to take on price discovery’s potential fame and occasional riches. Do you blame short sellers for not wanting to risk garnering the attention of and possible short covering ruin from the “wallstreetbets hedge fund”?
ONE MORE THING…
Plenty of optimism about this economy: The economy is on the cusp of a major boom and economists believe it could last
YES!!!!!!!!! GameStop plays to win: GameStop shares drop after Reddit-driven name plans a $1 billion stock sale
“Really below industry standard”: Not exactly how you want analysts to describe your risk management: ARK Invest’s High-Flying Flagship ETF Rated Neutral by Morningstar
If you’re feeling risk-averse, take up chess: Teaching children to play chess found to decrease risk aversion
The information and opinions contained in this newsletter are for background and informational/educational purposes only. The information herein is not personalized investment advice nor an investment recommendation on the part of Likely Capital Management, LLC (“Likely Capital”). No portion of the commentary included herein is to be construed as an offer or a solicitation to effect any transaction in securities. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
Past performance is not indicative of future performance. There can be no assurance that any investment described herein will replicate its past performance or achieve its current objectives.
Copyright in this newsletter is owned by Likely Capital unless otherwise indicated. The unauthorized use of any material herein may violate numerous statutes, regulations and laws, including, but not limited to, copyright or trademark laws.
Any third-party web sites (“Linked Sites”) or services linked to by this newsletter are not under our control, and therefore we take no responsibility for the Linked Site’s content. The inclusion of any Linked Site does not imply endorsement by Likely Capital of the Linked Site. Use of any such Linked Site is at the user’s own risk.